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Why Investors Are Too Complacent

A lack of risk-recognition repeats errors investors made five years ago.

You'd think that after the stock market crashed more than 50% in the span of just 18 months from 2007 to 2009, investors would remember what risk looks like. Yet investors increasingly appear to have forgotten just how cruel stocks can be in the short run, and that complacency could result in a nasty surprise for those who aren't prepared.

Yesterday the financial markets showed all the classic signs of a flight to safety, with stocks falling sharply while bonds gained ground and safe-haven commodity plays like gold and silver soared. Yet even as investors got more nervous, some key measures of their fear show that they're not giving much credit to everything that's going on in the investing world.

Why volatility is still missing in actionOne benchmark that investors like to look at when gauging fear or complacency is the S&P Volatility Index (VOLATILITYINDICES:^VIX). As news about Syria and the likely use of chemical weapons surfaced, investors bid up the price of short-term stock-index options enough to send the so-called "Fear Index" up 12% on the day, bringing its gains to more than 36% over the past two weeks.

Those who invest directly in volatility-tracking investment products saw comparatively modest but still significant returns. The iPath S&P 500 VIX Short-Term Futures ETN (NYSEMKT:VXX), which tracks near-term futures contracts on the Fear Index, rather than the spot index itself, picked up 8% yesterday and brought its two-week total return to almost 15%. The leveraged VelocityShares Daily 2x VIX ST ETN (NASDAQ:TVIX) did even better, with a better than 14% rise bring its two-week total to almost 30%.

On their face, those returns sound pretty substantial. But those products have both suffered big losses over the past year, with the iPath ETN falling by more than 60% and the VelocityShares ETN trading at just a tenth of its year-ago levels. Meanwhile, the inverse VelocityShares Daily Inverse VIX ST ETN (NASDAQ:XIV) has produced strong one-year returns of more than 70%, even after a recent drop in light of rising volatility levels.

Moreover, when you consider all the events that have the potential to destabilize the markets, putting the current level of the Volatility Index into historical perspective shows just how sedate it really is:

Syria is just the latest sign of geopolitical tension, with unrest in Egypt and Turkey also affecting the Middle East. Civil protests in Brazil have largely fallen from the headlines, but they also have a major potential impact on a key emerging-market economy that has been hard-hit by falling commodity prices and global macroeconomic sluggishness.

The Detroit bankruptcy has called the financial health of states and municipalities into question, and there is increasing attention on the wide gulfs between promises made to workers and the financial ability to make good on those promises.

As much as fears about the Federal Reserve's "tapering" of bond-buying have hit the market in recent months, investors still appear to believe that the Fed is generally on their side. If next month's announcement about the future of quantitative easing indicates that the Fed will pull back regardless of other tensions, investors could see it as a sign of worse things to come.

Yet even with all these events, the Fear Index rests well below levels it saw in late June following the Fed's initial QE-tapering announcement. It's even further below the yearly peak set in late December during the run-up to the fiscal-cliff debate and eventual resolution, and compared to the volatility highs during the financial crisis -- roughly five times higher than current levels -- what we're seeing now is insignificant.

Be aware of riskThe lesson from observing today's complacency isn't necessarily to pull all your money out of risky investments now. But make sure you think about risk management even as others are simply looking at the recent pullback as another buy-on-the-dip opportunity. This will prove an important part of making sure your long-term investing plan actually works.

Tune in to Fool.com for Dan's regular columns on retirement, investing, and personal finance.You can follow him on Twitter @DanCaplinger.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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